Management earnings forecasts and the market's reaction to predicted bias in the forecast

Abstract

Prior research regarding management earnings forecasts has failed to reject the null hypothesis that the forecasts are not biased. In this study, we find that short-term forecasts are pessimistically biased, while long-term forecasts are optimistically biased. When we pool the forecast observations, consistent with prior studies, we are not able to find the existence of bias. In addition, our evidence suggests that the magnitude of the bias is associated with ex ante information—the unexpected portion of the forecast, firm size, forecast horizon, firm performance, and growth potential of the firm. Since this information is publicly available when a forecast is announced, investors may use it to estimate the bias component included in the management earnings forecast. Our results indicate that while the bias component is predictable, the market still significantly responds to the predicted bias when the forecast is released. In addition, we find that the market's response to the predicted bias decreases as investors' private information search activity increases.